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Retirement, Risk and Creating a Lifetime Paycheck

Remember those kids from grammar school who were always top of the math class? They grew up to become actuaries. According to the web site of the American Academy of Actuaries, an actuary is an expert in “putting a price tag on risk.” They use math, statistics, economics and finance to predict the likelihood of future events and then try to come up with solutions.

They also appear to be the only people in the world who really understand pension plans.

Risks in Retirement

The Society of Actuaries (SOA) recently did an in-depth analysis of its 2009 study of the key risks in retirement. Since these guys are all about risk, it seems worth paying a little attention to the issues they highlight.

Two-thirds of those surveyed who are close to retirement, told the SOA that due to the economic situation of the past few years, they believed they will need to work longer. However, the actuaries warn that won’t be feasible for many in this tight job market. More than four out of 10 people end up retiring earlier than planned, their group reports. (For more on this topic, see our post Working Longer As The Retirement Solution Has Its Flaws.)

58% of retirees and 71% of those nearing retirement worried about maintaining the value of their savings and investments with inflation.

Retirees were less likely than they were in 2005 to have paid off their mortgage by the time they retire — 48% today down from 56% four years before.

43% of retirees surveyed had moved their assets to increasingly conservative investments, up from 33% in 2005.

What Actuaries Worry About

Though we worry about having enough in retirement, the SOA finds that those close to retirement are planning for periods that are actually much shorter than their remaining life expectancy. Seniors proved “fairly resilient” over the past few years, cutting back on spending to compensate for the economic downturn. “Whether this will be as true of the baby boom generation with its greater expectations relative to that of today’s retirees,” the SOA authors write, “will remain a topic of future surveys. ”

It will certainly take awhile before retirees feel as well-off as they did only a few years ago. The SOA study site Urban Institute figures that balances in retirement accounts — defined contribution plans and IRAs – aggregated to about $8.7 trillion in the third quarter of 2007. By the end of the first quarter of 2009, when the stock market bottomed out, they had lost $2.8 trillion or 32% of their value. Balances were back up to $8.1 trillion in the third quarter of 2010.

But we may be more worried than we need to be. If you factor in the value of Social Security benefits and pensions, a study by the National Bureau of Economic Research found that only about 15% of the financial wealth of those ages 53 to 58 is in stock. The study estimated that stock market declines would result in an average retirement delay of only a month-and-a-half, almost insignificant.

In another complex analysis, Michael D. Hurd and Susann Rohwedder of the RAND Corporation tried to determine the probability that the last survivor of a household would die with positive or negative wealth. They concluded that by their criteria, the majority of married couples were well prepared financially for retirement, though their consumption standard for a retired couple — $42,000 a year — might seem a tight budget to many.

What to Do ?

To get some ideas about what all this might mean to investors, we talked to Steve Vernon, a retired actuary based in Southern California, who now pens a blog on retirement “Money for Life” at CBS MoneyWatch. Vernon spent much of his professional career at consulting firm Watson Wyatt helping large corporations move from traditional pension plans to 401(k)s and manage their ongoing corporate risk.

He offered some straight forward advice:

If you don’t have enough money at retirement and can’t keep working for health reasons or just can’t find a job, cut your expenses. The key formula for retirement is to make sure your income exceeds your expenses: I (income) > E (expenses).

In retirement keep between 1/3 and 2/3 of your money in stocks as a way of protecting against inflation and planning for your own longevity.

Many people subscribe to a 4% rule, arguing that it’s “safe” to take 4% of your principle out to live on each year of retirement. If that makes sense to you, why not instead buy an immediate inflation-adjusted annuity at retirement earning you 5% a year and guaranteed to increase with inflation, for the rest of your life. (This is a bet on the solvency of the insurance company selling you the product, so Vernon bought several in different states, all below that state’s insured limit. Unlike bank accounts, annuities are not Federally insured, but state insurance commissions run recovery funds up to certain limits.) You can find companies willing to bid for your business on immediateannuities.com and other sites.

Structure your investments in a way that will let you sleep at night. Don’t put all your money in an annuity. It’s good to have some cash fund you can dip into, and people feel uneasy about giving up all control over their money.

Pay your mortgage off before you retire — you’ll feel less stressed by market dips and investment losses.

Keep your skills up to date as you near retirement especially if you plan to work after. That should be part of your retirement plan.

“People need to have longer planning horizons,” Vernon says. “When you’re working you live paycheck to paycheck. When you retire you have to think of a 20 and 30 year time frame.” He advises that we think about our retirement savings as the “generator of a lifetime paycheck.” Whether that comes from an annuity, taking 4% of your principle a year, or just from the interest and dividends on your investments, it’s a different way to live “paycheck” to “paycheck.”

What Type of Investor Are You?

Understanding your investing profile to achieve your financial goals starts with a few simple questions. The Investor Questionnaire, by Folio Investing, will help you understand your investment time horizon, investor profile and level of risk.